A Step in the Right Direction?
Establishing a stock market has been a hot issue under discussion in Ethiopia for almost two decades. While some argue that there is a need for a capital market, citing the existing shortage of finance both in local and hard currencies, others disagree, mentioning the immature financial reporting and fragile corporate governance systems, absence of the required legal framework, and a very weak private sector. Meanwhile, the government’s position is firm: setting up a stock market in no less than a year, if possible, before the end of 2020. EBR’s Samson Berhane investigates to find out whether the country is ready to institute a stock exchange.
In 1960, Ethiopia took the first steps towards share trading by establishing an institutional arrangement and opening a share exchange department in the then State Bank of Ethiopia. As the share market expanded, the Share Trading Group was set up in 1965. Within the Group, six institutions traded shares amongst themselves on an open bidding basis. This placed Ethiopia amongst the few African countries with a full-fledged stock market until the Group ceased to exist in 1974 when financial institutions and big companies were nationalized and put under government control.
Now, half a century later under Prime Minister Abiy Ahmed (PhD.), Ethiopia is once again attempting to establish a stock market. Just three months after he assumed power, Prime Minister Abiy announced that a stock market will be setup in Ethiopia by 2020. Yinager Dessie (PhD), Governor of the central bank, also affirmed this firm position of the current administration a month ago when he told the weekly English newspaper Capital that the central bank is preparing a document to table to the Council of Ministers in the near future.
Meanwhile, the business community in the capital, through the Addis Ababa Chamber and Sectoral Associations, expressed their dismay towards government, which they believe is not transparent enough about its actions regarding the stock market.
Anatomy of Stock Market
A stock market is no different from other markets, except for having a distinct feature in terms of types of products traded and its organization. It involves the trading of securities, which are legal documents showing an ownership position in a company (meaning shares) or a creditor relationship with a company or government, particularly stocks and bonds. Stock markets are classified in two groups: primary and secondary.
Primary markets are physical market places where companies offer their shares to members of the public for the first time. This is known as Initial Public Offering (IPO). Here, shares are sold through agents or banks on behalf of the issuing company. Secondary markets, on the other hand, provide a platform for the reselling of securities initially traded in the primary markets. The purchase and sale of shares and stocks in secondary markets is conducted in a very sophisticated marketplace where stocks and shares are traded as commodities.
In both markets, only the securities of companies that meet specific requirements of a given stock exchange can be traded. However, the volume of traded securities in the secondary markets is much larger than the primary markets. As a result, secondary markets play vital economic functions alongside facilitating the trading of stocks and shares. The first key function of secondary markets is the signaling of the efficiency level of companies. This emanates from the continuous adjustment (up and down) of the prices of securities. Through this, secondary markets direct capital to companies with higher performances, ensuring the efficient allocation of resources (in this case, capital).
The second vital role secondary markets play is allowing for the effective implementation of monetary policy. This is because central banks can control the amount of money circulating in the economy by selling and buying securities traded in the secondary markets.
Together with other variables, these two factors determine when and where stock markets should be established. This means stock markets will be instrumental when there is a need to allocate resources (capital) in an efficient manner. It is more useful in an economy where there is a scarcity of capital and the demand for finance (both in local and hard currencies) surpasses supply.
Where Ethiopia Stands
Ethiopia’s economy showed tremendous growth over the past 15 years. The country’s gross domestic product (GDP) grew by an average of 9.9Pct over the past decade, while its per capita income has doubled to almost USD1,000. Such an economic trajectory has placed the country among the top three fastest growing nations in the world.
The economic progress arises from the expansionary economic policy followed by the government, which is guided by a demand-side economic model that stresses investing vastly on public infrastructural projects in order to boost aggregate demand and accelerate economic growth. Parallel with the economic trajectory, aggregate demand increased as expected. The demand for food and non-food products skyrocketed. Yet, the aggregate supply remained unchanged as demand kept increasing.
One way of increasing aggregate supply could be enhancing local production by boosting the participation of the private sector. But the private sector remains small and fragile due to the lack of capital resulting from a financial industry not in a position to satisfy its financial needs.
Over the past two decades, the financial industry has witnessed the opening of 16 private banks and 16 private insurance companies. On top of this, 35 microfinance institutions are now operating in the country. Over the past 15 years, total deposits mobilized by commercial banks skyrocketed by 68-fold to almost ETB900 billion, while their outstanding loans rose by 19 times to ETB556.6 billion during the same period. Together with microfinance institutions, commercial banks helped the country raise its financial inclusion to 22Pct. Yet, this is not even enough to cover half of the nation’s demand for finance and this poses a big threat to the economy of the country.
As a result, starting and expanding business operations have been difficult, especially for the local private sector. With new investments requiring huge capital, persuading potential investors has become a daunting task and has discouraged many from forming share companies. This is because companies, at the earlier stages of establishment, encounter hurdles while attempting to sell shares to investors as they are usually viewed with skepticism.
“There is a lack of trust towards new companies even though there are many investors with the potential of forming strong share companies. It is very costly and extremely tiresome to establish a share company in Ethiopia,” says Abdurahiman Hussien, Deputy Chairperson of the organizing committee of Ramis Islamic Bank that is under formation with the goal of collecting two billion Birr in paid-up capital. “The challenge faced by new entrants attempting to establish share companies signals that the country cannot afford to have an unstructured market place for the trading of shares.”
Expanding a business by selling shares to investors, on the other hand, remains uncoordinated and largely informal in the country. Shareholders also face big challenges in getting potential buyers to sell stakes at reasonable prices. While such problems are common in non-financial companies as brokers attempt to get unfair commission from every sale that they facilitate, shareholders of banks and insurance companies face less challenges as there is a higher demand for their stakes and this is usually facilitated by insiders.
“The lack of viable alternatives such as publicly listed stocks is forcing investors to misallocate capital by buying assets such as shopping malls and other commercial properties. This capital could have been invested in more productive sectors such as manufacturing and technology that are transformational to the economy,” said Zemedeneh Negatu, an Investment Advisor. “It is also a panacea for talented people and creative companies that are starving for capital.”
In Ethiopia, the contribution of the private sector to the economy is very minimal while the state has a dominant role. Until 2019, there were 110 share companies with more than 100,000 shareholders, dozens of public enterprises, and few family-owned businesses as well as corporates with a turnover of over a billion Birr; while there were over 1,000 large tax payers with an annual turnover of above ETB35 million. Apart from this, it is micro businesses and small enterprises that are dominant in the country.
This is why researchers, scholars, and investors, have at different times, called for the introduction of a strong capital market that can satisfy financial needs with products tailored to those seeking finance. Those propagating such a move also demand for the change of the rudimentary primary market the country has. Ethiopia is amongst few countries that has not fully embraced the development of local capital markets, which can potentially increase access to local currency financing and thereby help manage foreign exchange risk and inflation better. On top of these, with the privatization and liberalization efforts being undertaken by the government, the calls for the development of a capital market and possibly a stock market get louder.
While the government’s pledge to establish a stock market has given much hope to institutions desperately looking for capital, it is also welcomed by those who believe it would alleviate the country’s suffering created by the shortage of finance both in local and hard currencies, as well as the balance of payment deficit.
But this is not a move supported by all. Scholars who are against the establishment of a stock market mention the low level of public awareness towards securities markets, lack of public confidence, absence of institutional capacity to facilitate securities trading, and presence of very weak private sector. They also assert that developing a stock market in a country where there is no legal, regulatory, accounting, tax, and supervisory systems needed to govern capital markets is not possible and will bring catastrophic outcomes.
“Perhaps, there could be investors that can take on a large risk, but there are also people who will invest their hard-earned money. Bearing this in mind, setting up a stock market without having the right infrastructure and legal framework is not advisable,” said Tesfaye Hailemichael, Vice President of Server Frontiers, an experienced financial expert with over three decades of experience.
Do the Pros Outweigh the Cons?
Studies conducted by different scholars indicate that establishing a stock market in Ethiopia would encourage investment by making the trading of shares quick and efficient, creating a positive impact on the economic growth of the country. It also has a positive role in de-concentrating ownership, improving accounting and auditing standards, and providing effective tools for monetary and fiscal policies, in addition to having a greater role in privatization efforts. Even for the current administration that is working to privatize large public enterprises, experts argue, having a stock market is very instrumental for initial and secondary public offerings.
In fact, there are scholars that argue that there is a suitable condition in Ethiopia for a stock market to flourish. Zemedeneh is one of the supporters who stress that a stock market can be very efficient way of deploying capital in Ethiopia. Citing the economic trajectory achieved by Ethiopia, he believes its sizeable private sector and public enterprises could benefit from an organized stock market as opposed to the disorganized way of trading shares. But he did not deny the fact that the country remains unprepared in terms of having audit and financial professionals, as well as financial reporting.
Japheth Ketto, former CEO of Uganda’s Capital Markets Authority, goes further. “The Ethiopian market can take advantage of the youth bubble as a market that is adventurous and amenable enough to new investment ideas. A vibrant private sector is music to a capital market’s ears. The ongoing development of the private sector in Ethiopia justifies the existence of a stock market,” argues Ketto. “At the beginning, undoubtedly, running a stock market will be difficult, be it for Ethiopia or any other country. The priority, however, should be making it sustainable by using different policy measures.”
According to Ketto, ensuring a conducive policy environment including tax incentives, strengthening regional collaboration, promoting transparent and accountable institutions, encouraging innovation, and investing in education are important to make stock markets sustainable.
But such arguments face outright rejections by those against establishing a stock market in Ethiopia. Although they agree that it would result in a huge inflow of forex and help Ethiopia solve its shortage of capital and balance of payment crisis, the success depends on the availability of a sound legal framework and strong institutions. Bearing this in mind, experts are strongly against the decision of the government to establish a stock market in no more than a year, and if possible, before the end of 2020. “Ethiopia is not ready to institute a stock market,” says Solomon Gizaw, Managing Director of HST Consulting, one of the leading advisory firms.
Solomon presents justifications in saying so. “I am not totally against a stock market, which I believe is very beneficial to our economy. But if we establish a stock market at the wrong time, we won’t benefit from it, but would rather end up confusing the public. In such a case, winning the hearts of the public would be very costly and difficult,” Solomon argues. “Bearing this in mind, there are issues that need to be implemented prior to launching the market.”
According to Solomon, the country neither has the infrastructure nor the human capital to establish a formal stock market. “Stock markets are needed in an economy where there is a need for huge capital for a long-term investment. In Ethiopia, even though there is such a need, there is no entity nor individual able to raise such large capital,” he says. “It is either pension funds or insurance companies through life funds that should have been able to do so. However, while pension funds in Ethiopia are used to finance budget deficits, insurance companies are weak and life insurance, which could have been a big source of capital, is at its infancy.”
Scholars who reject the establishment of a stock market in Ethiopia suggest that the government should emphasize reforming the banking system to fill the capital gaps of private firms. This is based on the assumption that the banking sector is more likely to meet the needs of a large chunk of the population rather than stock markets.
“The first step in the right direction should be developing bank-based financial systems, and this needs to be the prioritized agenda of the government,” Solomon argues. “If the government insists on setting up a stock market, it should be limited to dealers or over the counter (OTC) market.” An OTC market is a decentralized market involving the trading of stocks, commodities, currencies, or other instruments directly between two parties without a central exchange or broker.
The twin power of stock exchanges
Before 2008, stock markets were sparkling all over the world. The environment of easy-money making and the upward spiral of share prices made investments in higher yielding securities look like a new rush for gold. Everybody from investors to shareholders was on a sugar high, feeling as if the cavities were never going to come. Then the financial crisis arrived. When it cost the world trillions, the twin power of stock markets was revealed: the ability to raise capital for business expansion and bring prosperity for investors along with the potential to destabilize entire economies.
Beyond its positive impact on the trading of shares, empirical evidences suggest that setting-up a stock market is dependent on global and regional financial developments. In reality, there are different reasons for a country to establish a stock exchange, including proximity to countries with secondary capital markets and pressure from the Bretton Woods Institutions (World Bank and IMF).
However, countries that established exchanges because of international pressure have had very disappointing results as new systems are likely to be adopted superficially. This does not mean learning from neighboring countries will not pay off. Yet, there should be a boundary between coercion and peer influence, as studies suggest.
Currently, there are 29 exchanges in Africa, representing 38 nations’ capital markets. Established in 1887, the Johannesburg Stock Exchange is the biggest stock exchange in Africa with a market capitalization of USD987 billion and 388 companies listed. The Nigerian Stock Exchange birthed in 1960, and the Egyptian Stock Exchange comprising of two exchanges opened in 1883 in Alexandria and 1903 in Cairo, are the other top performing stock markets in Africa.
Although it is not as vibrant as in other parts of the continent, there are thriving exchanges in Eastern Africa. The Kenyan stock market has 62 listed companies with a market capitalization of USD21 billion, and accounts for one-fourths of its GDP. Its neighbor Tanzania has 28 listed companies, with a market capitalization of USD57.4 billion. Market capitalization of the 17 listed companies in Uganda has reached USD5.8 billion, accounting for 27.5Pct of the country’s GDP. On the other hand, Rwanda, with its seven listed companies in its stock market, registers a market capitalization of USD3.3 billion, equal to 35Pct of its GDP.
Despite such developments that have taken over a decade, experts still argue that East African countries are running the most expensive stock markets on the continent; a development blamed for the drop in trading volumes and the reduction in investor appetite. Activity across exchanges of the East African countries has been sluggish, chiefly because of the reduced corporate earnings of listed firms and declining participation by foreign investors, who contribute the lion’s share of the market’s liquidity.
In the past 100 years, the world had seen many of the negative impacts that come with stock markets. Especially in developing countries where there is underdeveloped legal, monetary, and institutional capacity, stock markets are likely to produce economic disasters that outweigh potential benefits. For instance Zimbabwe, a country with weak investment laws and no property rights, has learned the hard way when uncertainty over the direction of its policies shrank its exchange and damaged its economy in an unprecedented manner.
Even under these conditions, however, Zemedeneh believes African countries’ stock markets have served their purpose. “It is one alternative source of capital even though it is not liquid. The same is true for Ethiopia, which may face the same problem. But it should be noted that it is one more solution for companies seeking capital.”EBR
9th Year • Feb.16 – Mar.15 2020 • No. 83